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The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") included significant changes to the tax rules for qualified retirement plans. One of the opportunities resulting from EGTRRA is the Solo 401(k) plan. As the name implies, this qualified plan is a 401(k) plan designed for a self-employed individual or the sole owner-employee of a corporation. It works best when there are no other employees or a very small number of employees. Prior to EGTRRA, it was unusual for a single employee company to establish a 401(k) plan. This was due to the fact the owner of a Company, of which he or she was also the sole employee, could achieve the same benefits simply by establishing a profit sharing plan. In addition, the employer had other plan options that resulted in less administrative costs, such as a SEP. While in the past there was no reason for a sole owner to establish a 401(k) plan, significantly larger contributions now may be possible through a 401(k) plan.

EGTRRA Changes

Three changes to the tax laws resulted in the feasibility of the Solo 401(k) plan. These changes were:

1. Changes in the rules for deductibility of contributions to a profit sharing plan.
2. Increase to the annual addition limitations for defined contribution plans.
3. Self-employed plan participants can now take loans from a qualified retirement plan.

Other EGTRRA Changes

*The salary deferral limit in 2001 was $10,500

Catch-Up Contribution

Annual Addition to Defined Contribution Plan

Increase to Maximum Deduction Limit

Prior to EGTRRA, the maximum deduction limit to a profit sharing plan (including a 401(k) plan) was fifteen percent (15%) of eligible net compensation. A participant's compensation was reduced by salary deferrals to any 401(k) plan, cafeteria plan and/or transportation fringe benefit plan. Salary deferrals were considered an employer contribution in determining if the maximum deductible amount had been exceeded.

As the result of EGTRRA,

1. The maximum deduction limit for all defined contribution plans is increased to twenty-five percent (25%) of gross compensation.
2. Salary deferrals are not netted out of gross compensation.
3. Salary deferrals are no longer considered an employer contribution for purposes of determining if the maximum deductible amount has been exceeded. Thus, the maximum salary deferral ($13,000 in 2004) can be contributed in addition to a twenty-five percent (25%) of compensation employer contribution.

Example

Pre-EGTRRA

Sole owner has $100,000 of compensation. She makes a $10,000 salary deferral.

Salary deferrals reduce compensation for purposes of determining the maximum deduction.

Maximum deductible contribution = 15% of $90,000 ($100,000 - $10,000), or $13,500.

$10,000 salary deferral is considered an employer contribution.

Maximum deductible employer contribution = $13,500 - $10,000, or $3,500.

Total tax - deductible contribution by the sole owner = $13,500

A better alternative prior to EGTRRA was a profit sharing plan or Simplified Employee Pension (SEP). Because there would be no salary deferrals, the maximum deductible contribution would be 15% of $100,000, or $15,000.

Post-EGTRRA

Salary deferrals do not reduce earned income in determining maximum deductible contributions.

Maximum deductible contribution = 25% of $100,000, or $25,000.

Salary deferral is not considered an employer contribution.

Thus, in 2004, the sole owner can defer $13,000. Additionally, employer contribution = 25% of $100,000, or $25,000

Total contribution = $38,000.

If sole owner is age 50 or older in 2004, an additional $3,000 Catch-up Contribution can be deferred, making the total contribution $41,000.

	PRE-EGTRRA	POST-EGTRRA (2004)
Compensation	$100,000	$100,000
Salary Deferral	$10,000	$13,000
Net Compensation	$90,000	$100,000
Maximum Deduction	15%	25%
Deduction	$13,500	$25,000
Employer Contribution	$3,500	$25,000
Catch-up Contribution	-0-	$3,000
Total Contribution	$13,500	$41,000

In the Post-EGTRRA (2004) example above, if the sole owner established a profit sharing plan or SEP rather than a Solo 401(k) plan, the maximum contribution would equal 25% of $100,000, or $25,000. The Solo 401(k) plan permits the sole owner to contribute $16,000 more compared to the profit sharing plan or SEP.

Highly Compensated Owner

What if the sole owner earns $200,000 annual compensation instead of $100,000. Is the Solo 401(k) still a better option?

The maximum deductible contribution is 25% of $200,000, or $50,000. This exceeds the annual addition limit of $41,000; thus, the maximum annual contribution can be achieved through the employer's contribution, without salary deferrals by the sole owner.

However, if the sole owner is 50 years old or older, a Catch-up Contribution may be made to the plan if it is a 401(k) plan. The Catch-up Contributions are in addition to the maximum annual addition. In our example, the sole owner can contribute $44,000 to a Solo 401(k) plan, but only $41,000 to a profit sharing plan or SEP. In 2002, the Catch-up Contribution limit was only $1,000. In 2004, it is $3,000 and it increases to $5,000 in 2006. As the maximum amount of the Catch-up Contribution increases, the Solo 401(k) plan will prove to be advantageous for those sole owners desiring to maximize pre-tax contributions to a qualified retirement plan.

Participant Loans

In the past, loans to sole proprietors were considered to be prohibited transactions. An application could be made to the Department of Labor to obtain a prohibited transaction exemption for a loan; however, these rarely were considered by sole owners because of the time and expense involved in obtaining an exemption.

EGTRRA provided that sole proprietors can now obtain loans, which creates greater flexibility with respect to retirement plan assets and improves the availability of funds. Under the participant loan regulations, a participant can borrow the lesser of ½ of his or her vested account balance not to exceed $50,000 (offset by the highest outstanding loan balance in the past 12 months). Repayment of the loan must be made in no less than quarterly installments of principal and interest over a term not to exceed five years. However, if the loan proceeds are to be used to acquire the principal residence of the borrower, the term of the loan may exceed five years. A reasonable rate of interest must be applied to the loan.

A loan from a Solo 401(k) is fast to obtain because one is in effect taking the money from the sole owner's account. In many cases, the loan interest is fixed at prime rate for the duration of the loan, generally five (5) years or more. The loan payments, interest and principal are put back into the 401(k) account.

The loan from the Solo 401(k) plan is free of tax and early withdrawal penalty. However, if the loan is not paid back on schedule, the IRS will treat the balance of the loan as a distribution subject to income taxes and a possible 10% early distribution penalty.

Conclusion

EGTRRA significantly enhanced the ability of business owners to maximize contributions to a qualified retirement plan. This is particularly applicable to the sole business owner establishing a Solo 401(k) Plan. A properly established Solo 401(k) Plan can be designed to operate with limited administrative duties and without the regulatory burden normally associated with 401(k) plans maintained by larger employers.

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